Insurable interest is an investment with the intent to protect the purchaser from financial loss. It is a fundamental prerequisite for any insurance policy. Any person, item, event, or action can have insurable interest if its loss or damage results in a financial burden.
Understanding Insurable Interest
Generally, insurable interest is recognized when ownership, possession, or a direct relationship is established and therefore gives that person a financial stake in the subject. An insurance policy could be put in place to protect against this financial loss if anything were to occur to the person or asset. For the insurance policy to be valid, all parties must be competent to contract, have lawful consideration, be consenting to the agreement, and the insured must have an insurable interest in the matter.
Any person or entity that would not bear any financial hardship if any damage or loss of asset were to occur would not be considered to have an insurable interest. For example, people can have an insurable interest in their homes, cars, spouse, and jobs. The extent of the interest only stretches as far as the person’s or entity’s investment reaches.
For example, if two sisters co-purchase a home together worth $500,000, they each only hold a 50% investment in that property. Therefore, if anything were to happen to that home, they would each only receive 50% compensation from insurance.
What is Insurance?
Insurance is a contract that an individual or entity can enter into to receive financial protection from any losses that might occur with respect to their assets or anything else that could cause them financial hardship if lost. It can cover large and small losses that are consequences of damage to the insured property or person.
Insurance companies pool the risk of many individuals to limit their risk exposure. For any insurance company to issue insurance, they must confirm that the individual has an insurable interest in the item at hand. It assumes longevity of the subject, disregarding any potential unforeseen adverse events.
Insurable Interest in Life
Some individuals will have an insurable interest in a person’s life. For example, a spouse who relies on their partner for finances has an insurable interest. Furthermore, anyone who will suffer a financial loss given a specific individual’s passing would have an insurable interest. They may be an immediate family member, a more distant blood relative, a creditor, or a business partner/associate.
All of the above relationships would result in some loss for the connected partner. Insurable interest in a person’s life can be exercised by purchasing life insurance. The insurance policy would compensate the policyholder and cover their losses if anything were to happen.
There have been cases where people try to take advantage of insurance even if they do not have an insurable interest in a person’s life. For example, a friend would purchase life insurance for an elderly person or someone who is not in good health because the death of that person is likely.
However, Insurance companies caught onto the practice and put stricter regulations in place to prevent such occurrences. For example, facts about the insured person’s health and personal life must also be disclosed to help the insurance companies gauge the risk they are taking on and where the insurable interest lies.
Insurable Interest in Property
Homeowners can have an insurable interest in their property that can be covered by homeowners insurance. If a natural disaster, fire, or any other destructive event occurred and the person lost a portion or entirety of their property or home, they would receive financial compensation to the extent of the damage.
The four main types of homeowners insurance are interior damage, exterior damage, personal asset damage or loss, and injury on the property. The person may buy homeowners insurance for their own home but not the neighbor’s house across the street because they do not have an insurable interest in their property. It would also create a more significant moral hazard problem between the insurance company and the policyholder.
Interest in Lenders
If a bank or lender provides a loan or mortgage secured by the property or asset, they then have an insurable interest in that property or asset. If a borrower is provided with a loan to purchase a car, the bank will have an equivalent insurable interest in that car as was equal to the loan. It will decrease over time as the loan is paid back until it reaches zero, at which time the lender will no longer have an insurable interest in the car.
For example, if an individual wanted to purchase a home for $400,000 with a down payment of $75,000 and took out a mortgage for the rest, the bank would then have an insurable interest in the house of $325,000. If the borrower pays down the mortgage to $100,000 and then the home is destroyed in a fire, they would have 75% insurable interest in the home, and the bank would have 25%.
CFI offers the Certified Banking & Credit Analyst (CBCA)® certification program for those looking to take their careers to the next level. To keep learning and advance your career, the following resources will be helpful: